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Krugman Isn't (Quite) Right About Austrian Economics

New York Times columnist Paul Krugman calls out lots of folks for predicting that our fiscal and monetary policies would produce hyperinflation. Shouldn't these people rethink their basic economic models, he asks?

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That's a fair enough point. If your model was telling you that zero-interest rates or budget deficits at recent levels would produce very high price inflation, there's probably something wrong with it.

Yet the past couple of years have been truly extraordinary. Opportunities for revising the way you think about the economy have arisen over and over again. The only thing you needed to take advantage of these opportunities was an open mind.

This is one of the reasons that heterodox approaches to economics—such as Modern Monetary Theory and New Monetarism—and finance—such as the work on "safe assets" by Gary Gorton—have been able to garner so much attention recently. People are trying to figure things out, and want new tools to assist them in understanding the way the world works. (Read more: Modern Monetary Theory and Austrian Economics.)

But the Times' famous scribe isn't quite right when it comes to a broader point about the Austrian school of thought, the linchpin of free market economics. Krugman is right that many self-styled Austrian economics mavens predicted high inflation. The Austrian model, however, does not.

Part of the confusion lies in the well-known definitional dispute over what is meant by the term "inflation." In general, most people and economists use inflation to mean "rising prices." Austrian economics, however, treats rising prices as a contingent phenomenon of an increase in the money supply.

In other words, Austrians will insist that any increase in the money supply is inflation—as a matter of definition. But Austrian economics does not insist that this kind of inflation necessarily results in higher prices.

What seems to have happened is that at least a few prominent pundits who consider themselves students of famous Austrian economists muddled these two concepts, thus concluding that Austrian-style inflation leads to price inflation.

Or, perhaps more generously, they failed to make it clear that their concerns about "inflation" were not primarily concerns about rising prices.

This situation is not helped by the fact that we can find passages in the work of Ludwig Von Mises, in which rising prices are described as the "inevitable" consequences of monetary expansion. Yet, as Krugman notes, its possible for an advocate of an economic model to be wrong without the model itself being inaccurate.

Austrian economic models do generally claim that recessions are caused by what Krugman refers to as "a failure on the production side of the economy." However, they do not demonstrate that credit expansions in the face of mal-investment results in too much money chasing too few goods, hence leading to price inflation.

Rather, they show that credit expansions have the potential to further the mis-allocation of capital and therefore further distortions in the economy.

In an environment with lots of slack due to unutilized resources—excess labor, excess inventory, excess capital equipment—its altogether possible under Austrian models that the effect of a credit expansion will increase demand for those resources and stave off price deflation. In fact, this is what Austrian economics predicts.

That, in fact, seems to be what has happened over the past few years. A combination of a growing fiscal deficit and an accommodative monetary policy have helped prevent the housing slump and financial crisis from depressing prices generally. This is entirely in keeping with the Austrian approach to economics.

An earlier version of this article inadvertently published parts of Paul Krugman's original piece, which was linked to in the story.

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